After Emerging Markets Selloff, Some Investors Dip Toes Back In

Women relax in front of a large wave on Leblon beach in
Rio de Janeiro April 17, 2013.REUTERS/Sergio Moraes

NEW YORK (Reuters) - The threat of less central bank stimulus and
higher interest rates has crushed emerging markets more than most
assets in the past two
months, insome cases slashing the value of
stocks and bonds in developing countries to levels
not seen since the last financial crisis.

The slump after U.S.
Federal Reserve Chairman Ben
Bernanke signaled in May that the Fed expects to curb and
then end its bond-buying program in the next year if the economy improves
has pushed prices to levels that would have looked very appealing
only a few weeks ago. And someemerging market investors are buying,
even with the understanding that there is a big
risk markets have
further to drop.

There is every reason to be cautious: Many fund managers expect
lower growth inemergingmarkets. Some markets have suffered recently from steep
capital outflows, and the slowdown inChina has
affected other emerging economies, particularly
commodity producers. Still, emergingmarkets are expected to continue to grow
faster than developed countries.

Northern Trust Asset Management, for one, has remained
overweight inemerging market stocks through the slide.
The Chicago-based firm manages $810
billion in assets.

"If you're worried about performance in the next one or two quarters, then
it's hard to make a case about a visible catalyst
for emergingmarkets,"
said Jim McDonald, Northern Trust's chief investment strategist.
"But if you have a 12- to 18-month outlook, then this group will
work."

He said emerging-market
stocks are trading at around 10 times this year's earnings, or a
32 percent discount relative to the Standard & Poor's
500-stock index. The asset class's historic low is about eight
times earnings.

Emergingmarkets have typically traded at a 20
percent discount to the S&P 500 since 2005.

The price-to-book ratio of emerging market stocks on the MSCI stock
index is also showing sharp undervaluation at 1.45, not far from
the low of 1.36 hit during the depths of the financial crisis,
according to Morgan Stanley data. That is still far higher than
the 0.93 reached during the Asian crisis of 1997-98. The
price-to-book multiple measures the company's value if it goes
bankrupt.

"I wouldn't be surprised, though, if EM stocks come down further
because there would still be continued outflows from the sector,"
said Calderon of Hansberger, which is a long-term
investor inemerging market equities, with assets of
around $6.2 billion.

There is plenty of wreckage to survey for possible bargains.

The benchmark MSCI emerging market stock index is down about
11.3 percent this year, with much of the decline
coming in the past six
weeks. By contrast, the MSCI's all-country world equity index is
still up 4.8 percent this year, while the S&P 500 sports a
sizable 12.8 percent gain for 2013.

In the debt market,
the emerging market bond
yield spread on dollar-denominated bonds, a gauge of perceived
risk over safe-haven U.S. Treasuries, was at 342 basis points on
Thursday on the benchmark JP MorganEmergingMarkets USD Bond Index (EMBI+) . On
Tuesday, the spread was its widest in more than a year.

This index has fallen about 6 percent in June and is down more than 10.7
percent this year, after gains of more than 18
percent in 2012.

SLOWER EMERGING MARKET GROWTH

Emergingmarkets are experiencing a
slowdown in demand for
exports because of the weakness of the world's major
economies. China's downturn has had a
severe impact on many developing economies.

"China is likely to be far less
effective as an engine for global recovery than in previous episodes such as 2009,"
said Bhanu Baweja, an investment
strategist at UBS inLondon.

J.P. Morgan has reduced its growth forecast for emergingmarkets as a group in 2013 to 4.8 percent from its previous
estimate of 5.1 percent. The U.S. investment bank
expects emerging market
growth of 5.4 percent in2014.

Still those growth numbers are way above
estimates in developed markets, which are forecast to grow just 1
percent this year and 1.8 percent in 2014, J.P. Morgan data show.

VALUE IN BONDS

Brazilian government bonds
maturing in 2021 have
fallen by 245 basis points since May, while Mexican bond prices
have declined by 144 basis points, according to Morgan Stanley.
The firm's latest emerging market bond models suggest
those markets are now
undervalued.

"The selloff inMexico is not
justified," said Nicholas
Jacquiere, emerging market debt economist at
Standard Life Investments inLondon, which
manages assets of $272.6 billion.

"Growth inMexico has come down a little bit and it's going
through a soft patch, but that is good for bond investors because
that means the central bank could cut rates again this year if
growth continues to soften."

Standish Asset Management, a $170 billion fixed-income investment
firm inBoston, has bought local Mexican and Brazilian bonds
as yields have fallen. The average yield on emerging market local bonds is about 6.2
percent, Standish said, or about 100 basis points higher before
the selloff in May.

"Many investors are comfortable with the currency volatility
attached to these local bonds, and the expectation is
that in the medium
term, emerging market
currencies will appreciate," said Alexander
Kozhemiakin, managing director and emergingmarkets debt team leader at Standish.

Near-term risks inemerging market currencies have declined,
since many of the aggressive bets in favor of these assets have been
reduced. For instance, net longs - bets a currency will rise
- in the Mexican peso,
the most liquid emerging market currency, tumbled to
around $812 million, the latest data from the Commodity Futures Trading Commission show. That
is down sharply from roughly $6 billion in April.

Long positions in the
Brazilian real and Chilean peso have also substantially fallen,
according to Morgan Stanley data.

There is still a risk of further outflows from the local currency
debt sector, fund managers say. Morgan Stanley data
shows emerging market
institutional investors are still overweight on local debt
relative to their benchmark, suggesting more room to pare
positions should markets remain scary.

"When you see that exposure indicator going down, that's a sign
that the market is starting to clear their positions and
therefore there would be a sense of calm," said Rashique Rahman,
global head of emerging market strategy at Morgan
Stanley in New York.

Analysts at Bank of America/Merrill Lynch said in a Thursday note that institutions they
surveyed are raising cash in expectation of outflows, as investors
respond to the volatility. Once that is alleviated, the case for
long-term bets becomes clearer, fund managers said.